The report discusses the recovery plan options that FMI firms will be required to put in place in order to recover from financial stress. The focus is to allow these critical functions to continue without undue disruption to the markets. However, as can be seen, the different methods that can be employed may have considerable impact on market participants. Additionally, a firm constructing a stress test without considering the behaviour of the intermediaries could find their resulting plans less than useful. Therefore it is important not only for the infrastructure firms to understand the contents of the report, but also any firm that uses these services, or is a member/owner of these institutions. In short, it has some impact to all in the financial sector.
The FMI Operational Framework
The framework under which FMI firms are supposed to operate are determined by two documents; the first of which by CPSS-IOSCO is entitled ‘Principles for Financial Markets Infrastructure’ (PFMI). Published in April 2012, it outlines the minimum operational standards that infrastructure firms must adhere to. These principles regard the general organisation of FMI firms, looking at the legal status, the process of governance, and the risk management framework. Principles regarding liquidity risk incorporating credit risk, collateral and margin. Settlement and operational risk are also covered. There are also principles covering default management, access to services, efficiency and transparency.
The second document was published by the Financial Stability Board (FSB) and is applicable to all financial institutions, not just FMIs. It is entitled ‘Key Attributes of Effective Resolution Regimes for Financial Institutions’ and was published in October 2011. This document lays out the 12 essential features a resolution regime must have. These include issues regarding set-off, netting and collateralisation. It also includes funding of resolution, recovery and resolution planning, and access to information and information sharing.
So What Items do the Resolution Plans Cover?
The idea of resolution plans is that they allow the institution to deal with a stress event such as the failure of a counterparty, payment system or other dependent infrastructure, using addition capital and liquidity resources if necessary. In the CPSS-IOSCO paper ‘Recovery of Financial Market Infrastructures’ the following five categories of stress event are considered:
- Member or participant defaults: Members often provide the capital for an institution and so default of a member can impinge on the ability of the FMI to operate.
- Liquidity shortfalls: These can occur for several reasons, including the failure of a significantly large trade, or the downgrade of certain assets used as collateral.
- Replenishing financial resources: Like other financial institutions, FMIs have minimum capital requirements.
- Allocation of losses across participants.
- Re-establishing a matchbook.
Use of Recovery Tools
There are several reasons whereby firms may require the use of recovery tools, including:
- Uncovered losses caused by participant default: Counterparties being unable to meet their obligations may have a knock-on impact on the FMI itself.
- Uncovered liquidity shortfall: Where counterparty liquidity shortfalls have left the FMI short of liquidity.
- Losses from general business risk: These losses can concern an operational risk event and not be related to the performance of a particular customer.
- Losses from custody and investment risks: The result of the FMI firm investing its own or money held in custody.
Tools Available to FMIs and their Impact
Tools to allocate uncovered losses caused by participant default:
In situations where the prefunded financial resources are not enough to address all losses, the FMI will need to have tools that will allow it to cover the excess losses. One way to do so would be to require direct participants to commit to provide excess resources in the form of cash (this is called assessment power). The FMI may establish ex-ante rules that determine how the shortfall is allocated. This may be, for example, in proportion to the activity with the FMI or it may be a fixed amount up to a limit per participant. Both methods have their problems.
The first would mean that participants (mainly financial institutions) would have an open contingent obligation to the FMI that it could not control. Regulators may insist that capital has to be raised against such an obligation. Further, as this is likely to be drawn under a stress scenario the participants may not always be in a position to meet this obligation easily. Hence this method may spread contagion.
The second method may be problematic if the fixed amount that may be allocated is not enough to cover the shortfall. If this is the case, then the FMI would still be at risk and the measure would not have been successful.
Additionally a fixed allocation, or an allocation based on a metric, both have the effect of creating certain incentives or disincentives to use the FMI. Those most affected would have an interest to ensure that the FMI does not take excessive risk. Others may be encouraged not to use the FMI in order to avoid the risks. This would not be good for the system as a whole, as transacting through FMIs increases transparency and helps to reduce risk in the whole financial system.
Another recovery tool that may be used is to apply a ‘haircut’ to the variation margin. The variation margin represents profits made on a trade. The FMI firm may choose to take a pro-rata rate of the variation margin across all positions, or against the positions in the same product group as the incurred loss. This tool has the disadvantage that if used over time, participants may grow unwilling to honour the required variation out-the-money positions, which could result in costly legal proceedings. Furthermore, any such unwillingness could force regulators to conclude that the FMI lacks the financial resources to make the necessary payments. One advantage of this tool to the participant is there is a certainty of knowing their maximum exposure at any time. However, one should note that in extreme cases variation margin alone may not be enough.
An FMI firm may consider haircutting the initial margin amount. It would probably be limited to members and direct participants. This tool may be problematic, as in some jurisdictions the initial margin is treated much like client money and the FMI firm would be prohibited from accessing these funds. Where legally permissible, the use of these funds could trigger a loss of liquidity in those directly participating firms. Where a haircut is, or could be applied to indirect participants, it will act as a disincentive for them to use the FMI service, itself lowering the amount and number of initial margins available.
Tools to address uncovered liquidity shortfall:
An FMI firm in the event of a liquidity shortage may put in place several tools. One of the simplest would be to obtain liquidity from a third party. The issue here would be to ensure that third party is unlikely to be under liquidity stress at the same time that liquidity is needed by the FMI firm. FMI firms would need to justify the reliability of the liquidity source in their plans.
Another tool may be to obtain liquidity from its non-defaulting participants. There are different methods available. One may be to obtain funding only from those who are owed funds (i.e. the right not to pay participants under certain circumstances). Another route may be to require participants to pay in cash. The danger with this approach is that it may put the participants at risk.
Tools for CCPs to re-establish a matched book:
If a party defaults on an obligation and that obligation is large enough, it may result in the FMI firm not being able to match its assets and liabilities over time. This open position could also be the source of further market-based losses. A central counterparty (CCP) should put in place ex-ante rules to deal with this situation.
One method may be auctioning the defaulters’ position to the direct participants. This may have the effect of substantially limiting the loss. To incentivise participants to bid, unsold position losses may be allocated to those expected to bid for the type of position. One disadvantage with this method is it may undermine the contributions that participants make to a default fund. If contributors expect that loss-making positions are to be sold at auction, thereby protecting the default fund, then the incentive by the contributors to manage CCP risk may be reduced.
Another method considered is the forced allocation of contracts. The method could have built-in incentives, such as those not participating in auctions are more likely to have a position forced on them. This method has the advantages of being comprehensive; however the effect on different participants may vary depending on how they are structured. In some cases, for example, the forced allocation may place risks with the participant that they are not suited to take. It may also result in some cases to high amounts of concentration risk.
The third method to consider is the tear-up method, where all trades and the defaulted trade are considered void. This method can again be considered comprehensive, but it does have the risk of creating considerable market disruption. Non-defaulting participants may need those trades to complete hedges or complete other risk sensitive business. The impact of such a move could be more disruptive that any of the previous methods.
It is clear from this exploration into this paper that the issues raised are important to most – if not all – FIs. Depending on how an FMI chooses to resolve these issues will impact FIs in different ways. It is important that financial firms construct their own stress and scenario testing and recovery plans with a clear idea of how the many intermediaries are likely to respond. This is particularly true when considering market-wide stress scenarios. Overall it is important that firms be correctly informed and have adequate tools to model the different possible outcomes.
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